A safer banking system compared to our current dangerously misregulated one with so many systemic risks on steroids

What is a safer banking system?

One in which thousand banks compete and those not able to do so fail as fast as possible, before some major damage has been done, while even, as John Kenneth Galbraith explained, often leaving something good in their wake. 

What is a dangerous banking system?

One were all banks are explicitly or implicitly supported, by taxpayers, as long as they follow one standard mode that includes living wills, stress tests, risk models, credit ratings, standardized risk weights... all potential sources of dangerous systemic risks.

A bank system in which whenever there is a major problem, the can gets kicked down the road with QEs and there is no cleaning up, and banks just get bigger and bigger.

One that make it more plausible that the banks will all come crashing down on us, at the same time, with excessive exposures to something ex ante perceived safe that ex-post turned out risky, and therefore the banks holding especially little capital.

But you don’t worry; the regulators have it all under control with their Dodd-Frank’s Orderly Liquidation Authority (OLA). “Orderly”? Really?

So that is why when I hear about banks “cheating” with their risk models I am not too upset, since that at least introduces some diversity. 

Also that cheating stops, at least for a while, the Basel Committee regulators from imposing their loony standardized risk weights of 20% for what has an AAA rating, and so therefore could be utterly dangerous to the system; and one of 150% for the innocuous below BB- rated that bankers don’t like to touch with a ten feet pole.

How did we end up here? That is where you are bound to end up if you allow some statist technocrats, full of hubris, to gather in a mutual admiration club, and there engage into some intellectually degenerating incestuous groupthink.

Statist? What would you otherwise call those who assign a 0% risk weight to the Sovereign and one of 100% to the citizen?

And it is all so purposeless and useless!

Purposeless? “A ship in harbor is safe, but that is not what ships are for”, John A Shedd

Useless? “May God defend me from my friends, I can defend myself from my enemies”, Voltaire

In essence it means that while waiting for all banks to succumb because of lack of oxygen in the last overpopulated safe-haven available, banks will no longer finance the "riskier" future our grandchildren need is financed, but only refinance the "safer" present and past.

In April 2003, as an Executive Director of the World Bank I argued: "A mixture of thousand solutions, many of them inadequate, may lead to a flexible world that can bend with the storms. A world obsessed with Best Practices may calcify its structure and break with any small wind."

PS. FDIC... please don't go there!

Note: For your info, before 1988, we had about 600 years of banking without risk weighted capital requirements for banks distorting the allocation of bank credit to the real economy.

PS. The best of the Financial Choice Act is a not distorting, not systemic risks creating, 10% capital requirement for all assets. Its worst? That this is not applied to all banks.

PS. If I were a regulator: Bank capital requirements = 3% for bankers' ineptitude + 7% for unexpected events = 10% on all assets = Financial Choice Act
 

Mr R Gandhi, ignore the Basel Committee’s mutual admiration club, and concentrate on the needs or your India.

Mr R Gandhi, Deputy Governor of the Reserve Bank of India, at the FIBAC 2016 in a speech titled “New horizons in Indian banking”, Mumbai, 17 August 2016 said the following: 

“I regret that at the very end of these two days deliberations on future of banks, I have to paint such a dismal future for your existence as banks….One big area, you vacated and / or let others to occupy by your lackluster attitude is there for your rightful reclaim, if only you make concerted and conscious effort. That is SME financing. Small and medium sized enterprises (SMEs) are a major, yet often overlooked sector by formal financial institutions. The SMEs reportedly account for more than half of the world’s gross domestic product (GDP) and employ almost two-thirds of the global work force. However, they are the neglected lot world over. As reported by the International Financial Corporation (IFC), a “funding gap” of more than $2 trillion exists for small businesses in emerging markets alone...

I can only conclude with the idea that if you make yourself socially relevant, not just relevant in economic sense alone, you can have hopes to exist”

Holy moly. unless Mr R Gandhi is simply thickheaded and does not understand, he should be ashamed of trying to blame the banks for this ignoring his own responsibilities as a regulator.

Who told banks to get out of SME financing? The bank regulators did; by requiring banks to hold much more capital when lending to SMEs than when lending to those perceived as safer. That made it difficult for banks to earn competitive risk adjusted returns on equity lending to the SMEs.

Who made banks socially irrelevant? The bank regulators did, by regulating banks without ever having defined their purpose… like that of allocating credit efficiently to the real economy.

And since risk-taking is the oxygen of any development, a developing country like India is one of those who could least afford to introduce regulatory risk aversion. Not as if those developed can either, but at least they have reached higher altitudes before starting to climb down their mountains.

In 2007, at the High-level Dialogue on Financing for Developing at the United Nations, I explained why the Basel regulations were harmful to development, and my opinion was even reprinted in October 2008 in the Icfai University Journal of Banking Law.

Sadly though, as happens with most central bankers and regulators from developing countries, they end up more interested in being accepted by their peers in the developed countries, and in belonging to their mutual admiration club, than in doing what is best for their own countries.

Stiglitz doesn’t understand that regulators, when doubling down on credit risk perceptions, are bullying those perceived as “risky”

Joseph E. Stiglitz together with George A. Akerlof and A. Michael Spence won the 2001 Nobel Prize in Economics "for their analyses of markets with asymmetric information". The Nobel Prize website indicates that in the case of Professor Stiglitz his contribution was to show “that asymmetric information can provide the key to understanding many observed market phenomena, including unemployment and credit rationing.”

In a 1998 paper by Thomas Hellmann and Joseph Stiglitz titled “Credit and equity rationing in markets with adverse selection” we read: "The meaning of rationing: “Those entrepreneurs who are willing to accept the higher price are rationed in the sense that they cannot obtain funds at the same price as other observationally identical entrepreneurs. Those entrepreneurs who are not willing to accept the higher price fail to receive funding in this market. Some of them may seek funding in the other market. If there is rationing in the other market too, they may fail to obtain any funding. Even if there is no rationing some of them may not find any acceptable offer in the other market, and again they are left without funding. The point is that while an outside observer may look at this environment and argue that there are many opportunities for the entrepreneur to obtain funding, it may well be that the funding that is still available comes at unacceptable terms, and the funding that has acceptable terms is rationed." 

And in his most recent book “Re-writing the rules of the American Economy” 2016, in the “Fix the Financial Sector”, Stiglitz writes “it is regrettable that almost all of the discussions of reforming the financial sector have focused on simply preventing harm on the rest of society and not in developing a financial system that actually serves our society- for instance by helping to effectively finance small business, education and housing”.

Yet in his very long and somewhat questionable what-to-do list, Stiglitz does not include getting rid of the pillar of current bank regulations, the risk-weighted capital requirements for banks, those by which regulators bully those who are usually perceived as risky borrowers.

By allowing banks to leverage more with what is safe than with what is risky, banks now earn higher risk-adjusted returns on equity when lending to the safe than when lending to the risky… with all its logical consequences.

I have read Professor’s Stiglitz cv. (boy!) and in it I find absolutely nothing that indicates he has ever walked on main-street. So most probably he therefore knows nothing about the difficulties of SMEs and entrepreneurs have to access bank credit. These borrowers, perceived as risky, quite often have to cheat, lie, or at least withhold the whole truth, or even bribe someone, in order to get the opportunity they believe can transform their lives and that of their children. 

And all those difficulties were present even before regulators told the banks that, besides clearing for ex-ante perceived credit risks by means of risk premiums and amounts of exposure, they also had to clear for the same perceived risks in the capital. 

One should expect someone that has won a Nobel Prize researching “credit rationing” to know that any perceived risk, an information, even if perfectly perceived, leads to the wrong conclusions, if excessively considered. But apparently it is not so.

The current risk weight of an unrated SME or entrepreneur, “We the people”, is 100%. The corresponding risk-weights for the Sovereign is 0%, for the members of the AAArisktocracy 20% and for the financing of houses 35%.

For instance the 100% for SMEs and the 35% for houses will cause we end up in houses without the jobs to pay the mortgages and utilities.

For instance the 0% for the sovereign and the 100% for We the People means that regulators believe government bureaucrats can use bank credit better than citizens... an outrageous statism.

Stiglitz has also aspired to a lot of fame as a champion against inequality… but, though he won the “John Kenneth Galbraith Award, American Agricultural Economics Association, August 2004” perhaps he should have included in his academic library John Kenneth Galbraith’s “Money: “whence it came, where it went” (1975). There on job creation and fighting inequality we read:

“For the new parts of the country [USA’s West]… there was the right to create banks at will and therewith the notes and deposits that resulted from their loans…[if] the bank failed…someone was left holding the worthless notes… but some borrowers from this bank were now in business...[jobs created] 

It was an arrangement which reputable bankers and merchants in the East viewed with extreme distaste… Men of economic wisdom, then as later expressing the views of the reputable business community, spoke of the anarchy of unstable banking… The men of wisdom missed the point. The anarchy served the frontier far better than a more orderly system that kept a tight hand on credit would have done…. what is called sound economics is very often what mirrors the needs of the respectfully affluent.

The function of credit in a simple society is, in fact, remarkably egalitarian. It allows the man with energy and no money to participate in the economy more or less on a par with the man who has capital of his own. And the more casual the conditions under which credit is granted and hence the more impecunious those accommodated, the more egalitarian credit is… Bad banks, unlike good, loaned to the poor risk, which is another name for the poor man.”

Professor Stiglitz was the Chairman in the Commission of Experts of the President of the UN General Assembly on Reforms of the International Monetary and Financial System 2008 and 2009.

And, during the 2007 High-level Dialogue on Financing for Developing at the United Nations, from the perspective of the developing nations, I protested this regulatory risk aversion but no one really wanted to listen. 

And so when it all came down to the conclusions of the UN Conference Crisis & Development I suffered great disappointments.

I have said before and I repeat it again and again. Nobel Prizes should be recallable, especially if they are used for uttering opinions on matters the winners have no idea about… like bank regulations and Main Streets. Besserwissers from mutual-admiration-group-thinking-clubs monopolizing discussions, are just too costly for the future of our kids and grandchildren

The most important behavioral, cognitive psychology, research program ever

Bank system crises never ever result from excessive exposures to what is perceived as risky, these always results from excessive exposures to what was erroneously perceived as safe.

And yet bank regulators imposed on banks credit-risk-weighted equity requirements that are much higher for what is perceived as risky than for what is perceived as safe.

That is very clearly a monstrous mistake. It means that is something really bad happens to banks where that usually happens, regulators have made sure banks will stand there especially naked, with no equity to cover themselves up with. 

And my thesis is that the at-first-sight, Daniel Kahneman's “System 1: Fast, automatic, frequent, emotional, stereotypic, subconscious” standard basic intuition of “risky-is risky and safe-is safe”, is way too strong so as to permit opening a more reflective “System 2: Slow, effortful, infrequent, logical, calculating, conscious” analysis… and this most specially if that means questioning some other members of a mutual-admiration/ mutual-importance-reinforcement club. 

And that is the subject I would like to see researched by experts in behavioral finance and in cognitive psychology.

But why do I call this “the most important research program ever”?

Easy! Those regulations allow banks to leverage the back-stop supports that for instance central banks give more on assets perceived as safe than on assets perceived as risky; and that means banks will obtain higher risk-adjusted returns on their equity on assets perceived as safe than on assets perceived as risky.

That has introduced a regulatory risk aversion that seriously distorts the allocation of bank credit to the real economy.

And since risk-taking is the oxygen of any development, and what helped to bring the Western world to where it is, suspending it, de facto prohibiting banks from taking risks on the “risky”, our economies will first stall and then fall. And I hope you’d agree that’s not entirely unimportant.

Reading Daniel Kahneman's "Thinking Fast and Slow"
https://www.americanbanker.com/opinion/basel-iii-doubles-down-on-basel-iis-mistake